Activity-Based Costing:
A Tool to Aid Decision Making
Chapter 7
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
7-2
Activity–Based Costing (ABC)
ABC is designed to
provide managers with
cost information for
strategic and other
decisions that
potentially affect
capacity, and therefore,
affect “fixed”
as well as variable
costs.
ABC is a
good supplement
to our traditional
cost system
I agree!
7-3
Learning Objective 1
Understand activitybased costing and how it
differs from a traditional
costing system.
7-4
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Manufacturing
costs
Nonmanufacturing
costs
Traditional
product costing
ABC
product costing
❶ ABC assigns both types of costs to products.
7-5
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Traditional
product costing
Nonmanufacturing
costs
Mos
t, bu
not
t
all
Some
All
Manufacturing
costs
ABC
product costing
❷ ABC does not assign all manufacturing costs to products.
7-6
How Costs are Treated Under
Activity–Based Costing
Level of complexity
ABC differs from traditional cost accounting in three ways.
Activity–Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Number of cost pools
❸ ABC uses more cost pools.
7-7
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Each ABC cost pool has its
own unique measure of activity.
Traditional cost systems usually rely
on volume measures such as direct labor
hours and/or machine hours to allocate
all overhead costs to products.
❸ ABC uses more cost pools.
7-8
How Costs are Treated Under
Activity–Based Costing
Activity
An event that causes the
consumption of overhead
resources.
Activity
Cost Pool
A “cost bucket” in which
costs related to a single
activity measure are
accumulated.
$$
$
$ $
$
7-9
How Costs are Treated Under
Activity–Based Costing
Activity
Measure
An allocation base
in an activity-based
costing system.
The term cost driver is
also used to refer to
an activity measure.
7-10
How Costs are Treated Under
Activity–Based Costing
Two common types of activity measures:
Transaction
driver
Duration
driver
Simple count
of the number
of
times an
activity
occurs.
A measure
of the amount
of time
needed
for an activity.
7-11
How Costs are Treated Under
Activity–Based Costing
ABC defines
five levels of
activity
that largely do not
relate
to the volume of
units
produced.
Traditional cost systems usually rely on volume
measures such as direct labor hours and/or machine
hours to allocate all overhead costs to products.
7-12
How Costs are Treated Under
Activity–Based Costing
Unit-Level
Activity
Batch-Level
Activity
Manufacturing
companies typically combine
their activities into five
classifications.
Product-Level
Activity
Organizationsustaining
Activity
Customer-Level
Activity
7-13
Characteristics of Successful ABC
Implementations
Strong top
management support
Link to evaluations
and rewards
Cross-functional
involvement
7-14
Baxter Battery – An ABC Example
Manufacturing overhead is allocated to products using
a single plantwide overhead rate based on machine hours.
7-15
❶ Define Activities, Activity Cost
Pools, and Activity Measures
At Baxter Battery, the ABC team selected the following
activity cost pools and activity measures:
7-16
❶ Define Activities, Activity Cost
Pools, and Activity Measures
• Customer Orders - assigned all costs of resources
that are consumed by taking and processing
customer orders.
• Design Changes - assigned all costs of resources
consumed by customer requested design changes.
• Order Size - assigned all costs of resources
consumed as a consequence of the number of units
produced.
• Customer Relations – assigned all costs associated
with maintaining relations with customers.
• Other – assigned all organization-sustaining costs
and unused capacity costs
7-17
Learning Objective 2
Assign costs to cost pools
using a first-stage
allocation.
7-18
❷ Assign Overhead Costs to
Activity Cost Pools
7-19
❷ Assign Overhead Costs to
Activity Cost Pools
Direct materials, direct labor, and shipping are excluded
because Baxter Battery’s existing cost system can
directly
trace these costs to products or customer orders.
7-20
❷ Assign Overhead Costs to
Activity Cost Pools
At Baxter Battery the following distribution of resource
consumption across activity cost pools is determined.
7-21
❷ Assign Overhead Costs to
Activity Cost Pools
Indirect factory wages
$6,000,000
Percent consumed by customer orders
30%
$1,800,000
7-22
❷ Assign Overhead Costs to
Activity Cost Pools
Factory equipment depreciation
$3,500,000
Percent consumed by customer orders
20%
$ 700,000
7-23
❷ Assign Overhead Costs to
Activity Cost Pools
7-24
Learning Objective 3
Compute activity
rates for cost pools.
7-25
❸ Calculate Activity Rates
The ABC team determines that Baxter Battery will
have these total activities for each activity cost pool:
▫
▫
▫
▫
10,000 customer orders,
4,000 design changes,
800,000 machine-hours,
2,000 customers served.
Now the team can compute the individual
activity rates by dividing the total cost for
each activity by the total activity levels.
7-26
❸ Calculate Activity Rates
7-27
Activity–Based Costing at Baxter
Battery
Direct
Materials
Direct
Labor
Shipping
Costs
Traced
Traced
Traced
Overhead Costs
Cost Objects:
Products, Customer Orders, Customers
7-28
Activity–Based Costing at Baxter
Battery
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Customer
Orders
Design
Changes
Order
Size
Customer
Relations
Cost Objects:
Products, Customer Orders, Customers
Other
7-29
Activity–Based Costing at Baxter
Battery
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Customer
Orders
Design
Changes
Order
Size
Customer
Relations
Other
Second-Stage Allocations
$/Order
$/Change
$/MH
$/Custom
er
Cost Objects:
Products, Customer Orders, Customers
Unallocate
d
7-30
Learning Objective 4
Assign costs to a cost
object using a secondstage allocation.
7-31
❹ Assigning Overhead to Products
Baxter Battery Information
SureStart
1. Requires no new design resources.
2. 800,000 batteries ordered with 4,000 separate orders.
3. Each SureStart requires 36 minutes of machine
time for a total of 480,000 machine-hours.
LongLife
1. Requires new design resources.
2. 400,000 batteries ordered with 6,000 separate orders.
3. 4,000 custom designs prepared.
4. Each LongLife requires 48 minutes of machine
time for a total of 320,000 machine-hours.
7-32
❹ Assigning Overhead to Products
7-33
Assigning Overhead to Customers
Let’s take a look at how Baxter Battery’s system works for
just one of the 2,000 customers – Acme Auto Parts who
placed a total of twelve orders. Note that the four orders
for LongLifes required a design change.
Orders
1. Eight orders for 60 SureStarts per order.
2. Four orders for 50 LongLifes per order.
Machine-hours
1. The 480 SureStarts required 288 machine-hours.
2. The 200 LongLifes required 160 machine hours.
7-34
Assigning Overhead to Customers
7-35
Learning Objective 5
Use activity-based
costing to compute
product and customer
margins.
7-36
❺ Prepare Management Reports
Product Margin Calculations
The first step in computing product margins is to
gather each product’s sales and direct cost data.
7-37
❺ Prepare Management Reports
Product Margin Calculations
The second step in computing product margins is to
incorporate the previously computed activity-based
cost assignments pertaining to each product.
7-38
❺ Prepare Management Reports
Product Margin Calculations
The third step in computing product margins is to
deduct each product’s direct and indirect costs
from sales.
7-39
❺ Prepare Management Reports
Product Margin Calculations
The product margins can be reconciled with the
company’s net operating income as follows:
7-40
❺ Prepare Management Reports
Customer Margin Analysis
The first step in computing Acme Auto Parts’ customer
margin is to gather its sales and direct cost data.
7-41
❺ Prepare Management Reports
Customer Margin Analysis
The second step is to incorporate Acme Auto Parts’
previously computed activity-based cost assignments.
7-42
❺ Prepare Management Reports
Customer Margin Analysis
The third step is to compute Acme Auto Parts’ customer
margin of $384 by deducting all its direct and indirect
costs from its sales.
7-43
Product Margins Computed Using the
Traditional Cost System
The first step in computing product margins is to
gather each product’s sales and direct cost data.
7-44
Product Margins Computed Using the
Traditional Cost System
The second step in computing product margins is
to compute the plantwide overhead rate.
Plantwide manufacturing
overhead rate
=
$14,000,000
800,000 MH
= $17.50 per machine-hour
7-45
Product Margins Computed Using the
Traditional Cost System
The third step in computing product margins is
allocate manufacturing overhead to each product.
480,000 hours × $17.50 per hour = $8,400,000
7-46
Product Margins Computed Using the
Traditional Cost System
The fourth step is to actually compute the
product margins.
7-47
Differences Between ABC and
Traditional Product Costs
The traditional cost
system overcosts the
SureStarts and reports
a lower product
margin for this product.
The traditional cost
system undercosts the
LongLifes and reports
a higher product
margin for this product.
7-48
Differences Between ABC and
Traditional Product Costs
There are three reasons why the
reported product margins for the two
costing systems differ from one another.
❶Traditional costing allocates all manufacturing
overhead to products. ABC costing only assigns
manufacturing overhead costs consumed by
products to those products.
7-49
Differences Between ABC and
Traditional Product Costs
There are three reasons why the
reported product margins for the two
costing systems differ from one another.
❷ Traditional costing allocates all manufacturing
overhead costs using a volume-related allocation
base. ABC costing also uses non-volume related
allocation bases.
7-50
Differences Between ABC and
Traditional Product Costs
There are three reasons why the
reported product margins for the two
costing systems differ from one another.
❸ Traditional costing disregards selling and
administrative expenses because they are
assumed to be period expenses. ABC costing
directly traces shipping costs to products and
includes nonmanufacturing overhead costs caused
by products in the activity cost pools that are
assigned to products.
7-51
Targeting Process Improvement
Activity-based management is
used in conjunction with ABC to
identify areas that would benefit
from process improvements.
While the theory of constraints
approach discussed in Chapter 1
is a powerful tool for targeting
improvement efforts, activity rates
can also provide valuable clues on
where to focus improvement efforts.
Benchmarking can be used to compare activity cost
information with world-class standards of performance
achieved by other organizations.
7-52
Activity-Based Costing and External
Reporting
Most companies do not use ABC
for external reporting because . . .
1.
External reports are less detailed than internal
reports.
2.
It may be difficult to make changes to the company’s
accounting system.
3.
ABC does not conform to GAAP.
4.
Auditors may be suspect of the subjective allocation
process based on interviews with employees.
7-53
ABC Limitations
Substantial resources
required to implement
and maintain.
Resistance to
unfamiliar numbers
and reports.
Desire to fully
allocate all costs
to products.
Potential
misinterpretation of
unfamiliar numbers.
Does not conform to
GAAP. Two costing
systems may be
needed.
ABC Action Analysis
Appendix 7A
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
7-55
Learning Objective 6
(Appendix 7A)
Prepare an action
analysis report using
activity-based costing
data and interpret the
report.
7-56
Appendix 7A: ABC Action Analysis
Conventional ABC analysis does not
identify potentially relevant costs. An
action analysis report helps because it:
• Shows what costs have been
assigned to a cost object.
• Indicates how difficult it would be to
adjust those costs in response to
changes in the level of activity.
7-57
Appendix 7A: ABC Action Analysis
Constructing an action analysis report
begins with the first-stage allocation process.
In addition to computing an overall activity
rate for each activity cost pool, an activity
rate is computed for each type of overhead
cost that is consumed supporting a given
activity.
Let’s revisit the stage-one allocations
from the Baxter Battery Company example
that we discussed earlier.
7-58
Appendix 7A: ABC Action Analysis
$1,800,000 ÷ 10,000 orders = $180 per order
Other entries in the table are computed similarly.
7-59
$180 per order × 4,000 orders = $720,000
Other entries in the table are computed similarly.
7-60
$180 per order × 6,000 orders = $1,080,000
Other entries in the table are computed similarly.
7-61
Appendix 7A: ABC Action Analysis
Next, label each cost using an ease of adjustment
code:
• Green costs adjust more or less automatically to
changes in activity level without any action by
managers.
• Yellow costs can be adjusted to changes in activity
level, but it would require management action to
realize the change in cost.
• Red costs can be adjusted to changes in activity
level only with a great deal of difficulty and with
management intervention.
7-62
Appendix 7A: ABC Action Analysis
Using a Modified Form of
Activity-Based Costing to
Determine Product Costs
for External Reports
Appendix 7B
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
7-64
Learning Objective 7
(Appendix 7B)
Use activity-based
costing techniques to
compute unit product
costs for external
reports.
7-65
Appendix 7B
A modified form of activity-based
costing can be used to develop product
costs for external financial reports.
ABC product costs:
• Include organization-sustaining costs
and unused capacity costs.
• Exclude nonmanufacturing costs even
if they are caused by the products.
7-66
Appendix 7B
Simmons Industries provides the following information
for the company as a whole and for its only two
products—deluxe and standard hedge trimmers.
7-67
Appendix 7B
Assuming that Simmons’ traditional cost system relies
on one predetermined plantwide overhead rate with
direct labor-hours (DLHs) as the allocation base, then
its plantwide overhead rate is computed as follows:
Predetermined
=
overhead rate
$1,800,000
400,000 DLHs
= $4.50 per DLH
7-68
Appendix 7B
Simmons’ traditional cost system would
report unit product costs as follows:
2.0 DLH × $4.50 per DLH
1.0 DLH × $4.50 per DLH
7-69
Appendix 7B
The ABC project team at Simmons has
developed the following basic information.
7-70
Appendix 7B
We can calculate the following activity rates:
Using the new activity rates, let’s assign overhead
to the two products based upon expected activity.
7-71
Appendix 7B
Deluxe Product
Standard Product
7-72
Appendix 7B
Activity-based unit product costs for both product lines
7-73
Appendix 7B
Activity-based unit product costs for both product lines
$1,130,000 ÷ 100,000 units
$670,000 ÷ 200,000 units
7-74
Appendix 7B
Comparing the two approaches:
Note that the unit product cost of a Standard unit
decreased from $44.50 to $43.35 . . . . .
. . . . . while the unit cost of a Deluxe unit increased from
$71.00 to $73.30.
7-75
End of Chapter 7B